Patents and Innovation Economics

Whether you love or hate Bitcoin and cryptocurrencies you have to admit that it is one of the greatest economic experiments of all time.[1] It is very rare in economics to have a well-defined and controlled experiment. I learned about this experiment in a decentralized private currency with a limited supply by 2012. At the time it was not clear if this experiment would ever really get off the ground. Bitcoin was valued at about $13, with a market capitalization around $15 million. In addition, it was difficult to buy and sell Bitcoins. Despite this I had conversations with people about the questions Bitcoin posed, particularly about the nature of money. There had been other cryptocurrencies before Bitcoin and when they got traction governments shut them down.

Now it is clear that Bitcoin, cryptocurrencies, and the underlying technology (decentralized, trustless, blockchains) are here to stay. A single Bitcoin is valued at over $6,300.00 and the total market capitalization of cryptocurrencies is around $181 billion. This is small compared to the FOREX market, but too large to ignore, which means the economic experiments will be played out. Here are just some of the questions posed by this experiment.

1) What is money?

Bitcoin and most cryptocurrencies do not actually have a physical or even computer coin or token. They are in fact just ledgers where the “coin” is the unit of value. The ledgers show who paid whom what and a positive account shows that you have provided value and are owed (or at least hope to) obtain value from the community in the future. If Bitcoin is successful it will show that money is not a thing, it is really just an accounting system that is it is just information.

It will also show that money is technology. Andreas Antonopoulos points out that the last real upgrade to that technology was the credit card, introduced by Dinner’s Club in 1950.

2) Does Money Have Inherent Value?

Or stated another way does money need to have an inherent value? Bitcoin does not have inherent value and in fact nothing has inherent value. For something to have value means it has to have value to someone. Value cannot be separated from the valuer. The only things that even come close to having inherent value to humans are food, water, and air. If Bitcoin succeeds it should settle the question of inherent value.

3) Do We Need Legal Tender Laws for Money to Work?

Most people seem to assume that money must be backed by a government or it will not work. Legal tender laws are laws that state you must accept the legal tender as settlement for any debts public or private. Of course, there are many examples in history where people used gold and silver as money that was not endorsed or backed by any government. The United States did not have any legal tender laws from the Constitution until the Civil War. If Bitcoin succeeds then it will be clear that money can be private, i.e., not backed by a government and legal tender laws. If you want to know more about legal tender laws in the U.S. see Money and Banking.

4) Is a Low Rate of Inflation Good for the Economy?

The Federal Reserve and most central banks argue that a little inflation is good for the economy. We are warned that without inflation we might fall into deflation, which caused the Great Depression. In the United States the target inflation rate is 2% per year, which means the purchasing power of a dollar today would be ¼ of what it will be in 70 years later. Even Milton Friedman argued that the money supply should grow at the same rate as the economy. According to Friedman this would keep the value of the dollar stable. This means if the economy grows at 3% per year then according to Friedman the money supply would grow at 3% per year. One question Friedman does not answer is who benefits from this growth in the money supply? The answer is the Federal Reserve and the U.S. government, essentially get 3% of the value of the economy in this example for doing nothing. Also note that the U.S. was in a deflationary period in the 1880s and 1890s and it was a time of extraordinary economic and technological growth.

Bitcoin has an inflation rate (supply increase) that is used to pay the miners during the start-up years. Presently the supply increase is about 4% per year. In order to convert this into an inflation rate the way the term is commonly used in the United States, we would have to subtract out the growth rate of the economy. The expected growth rate of the U.S. economy this year is 2.7%. Thus the inflation rate for Bitcoin is 1.3%, which is less than the Federal Reserve’s target rate. Also Bitcoin’s inflation rate slows down overtime and the total number of Bitcoins that can ever be produced is 21 million.

If Bitcoin succeeds, we will see whether a little inflation is good for the economy. We will also see if private citizens prefer to hold a devaluing currency or value increasing currency.

5) Do We Need Central Banks?

Central Banks are a fairly recent phenomenon. The United States did not have a central bank until the creation of the Federal Reserve in 1913. The U.S. did have national banks, but these were not central banks. A central bank has control over the currency of a nation and through convoluted processes creates and destroys money to “manage” the economy and to fund the government. For more see How Central Banks Create Inflation. The record of the Federal Reserve of “managing” the economy is very checkered including the Great Depression, the inflation and high unemployment of the 1970s, and losing 95% to 97% of the purchasing power of the dollar during its existence.

If Bitcoin succeeds, it will end the power of or at least significantly diminish the power of central banks. We will then see if a central bank is necessary to create prosperity and smooth out the ups and downs of the economy.

6) Do We Need Securities Regulations – the SEC in the U.S.?

Securities like stocks and bonds were mainly regulated by common law fraud and contract law until the 1920s in the United States. The justification for securities regulations have always been to protect investors. There have been a number of studies on point and not one of them has shown that investors have done better because of securities laws and some have shown they do worse.

Bitcoin’s technology has the potential to create stocks, bonds and other securities. However, it is not as clear that these can escape the regulatory rules in the way that Bitcoin can. Already we have seen crypto-assets created that bypass both Venture Capitalists, Wall Street, and securities regulations. Before the creation of the SEC in the United States in the 1930s this was quite common.

If Bitcoin’s technology can escape securities regulations, we will see if securities regulations help investors or if they just entrench large Wall Street banks.

7) Is a Financial Sector that Takes Up 20% of the GDP Good for the Economy?

Cash is almost dead in most modern economies, which means we pay for goods and services with credit or debit cards. This “convenience” costs at least 3% of the transaction price assuming the bill is paid immediately. It also puts the banks and government in between almost every transaction. Securities regulations and banking regulations are so complicated that people are forced to use financial intermediararies for almost any financial transaction. In 1947 the financial sector was only 10% of the United States GDP. Finance does not create wealth, it just greases the wheels of transactions. For instance, money is just a way for one person to sell their “time” and buy goods.

Bitcoin and Bitcoin’s underlying technology if they succeed may significantly shrink the financial sector. For instance, by allowing everyone to be their own bank or credit card company or loan originator the fees to the financial sector will be severely undercut. If Bitcoin succeeds we will see if the large financial sector was creating wealth or consuming it.

8) Do We Need Income Taxes?

Bitcoin has the potential to severely undermine income taxes and capital controls. Do people think they get value for their income taxes? Are income taxes a method of raising revenue or a system for punishing the politically un-connected or unpopular?

9) Can Bitcoin Decentralize the Internet?

The Internet was built on a series of decentralized technologies. Because of the inefficiencies of our financial sector, the only way to monetize the Internet was with centralized systems like Google, eBay, Youtube, Amazon, etc. Efficient micropayments that can be implemented using Bitcoin technology have been postulated as a way to decentralize the Internet and return it to its origins. Only time will tell.

10) Do We Need the NSA to Protect Us?

The technology behind Bitcoin has the potential to store and transfer information that is not trackable and cannot be hacked. These systems are just being developed. If they are successful, we will find out if the NSA was just a boondoggle or if it was truly protecting us, not the government.

[1] Unless you are an Austrian Economist and then you do not think experiments and therefore observation are relevant to economics, which means you are not doing science.

Central Banks like the Federal Reserve in the United States are different than commercial fractional reserve banks. As explained in the article A Brief History of Central Banks on the Federal Reserve Bank of Cleveland’s website,

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.[1]

Unfortunately, this definition misses that fact that central banks are monopolies and therefore not part of capitalism (free market).

A central bank, or monetary authority, is a monopolized and often nationalized institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is responsible for the formulation of monetary policy and the regulation of member banks.[2]

According to this definition a central bank has control over “printing” the national currency, which in the modern world can be done by just a computer entry. If you look into the Federal Reserve of the United States you will find that they have control over printing paper money, while the Treasury has control over minting coins. However most currency today is just a computer entry and here the answers get even more obscure. The best answer is that direct money creation is a dance between Congress, the Treasury, and the Federal Reserve. Everything becomes convoluted when a central bank is added into the equation and so far we have only discussed direct creation of currency not open market operations, discount window lending, and changes in reserve requirements. I think politicians and central banks, not to mention the largest banks and brokerages, like this obscurity.

In order to make this less obscure I will analyze each “tool” of a central bank separately. In addition, we are going to analyze the direct money creation issue through the lens of Modern Monetary Theory (MMT). One reason to look at MMT it is how most central bankers see the world, which is illuminating. It also points out some uncomfortable truths and exposes some of the Keynesian nonsense. Wikipedia explains MMT as:

Modern Monetary Theory (MMT or Modern Money Theory, also known as Neo-Chartalism) is a macroeconomic theory which describes and analyses modern economies in which the national currency is fiat money, established and created by the government. The key insight of MMT is that “monetarily sovereign government is the monopoly supplier of its currency and can issue currency of any denomination in physical or non-physical forms. As such the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors. Thus, insolvency and bankruptcy of this government is not possible. It can always pay”.[3]

This quote is very revealing, especially the idea that “the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors.” At the beginning of this series I pointed out that when money enters the equation in economics, people think magic happens and logic disappears. The MMT people think they can create wealth by manipulating money. The MMT advocates believe money and banking allow for good magic and Austrian Economics argues that money and banking are bad magic (meaning it destroys wealth).

This is why I wrote my book on The Source of Economic Growth, which shows that increases in real per capita wealth are created by applying our reason to the objective problems of life – in other words by inventing and increasing our level of technology. Money is not wealth, as I showed earlier in this series. Money and banking are mainly a lubricant for the economy. Of course real inventions in money and banking do increase our per capita wealth, such as cryptocurrencies might do if the governments (central banks) of the world would get out the way. Cryptocurrencies hold the promise of significantly reducing the cost of transferring money around the world.

Modern Monetary Theory is correct that the government cannot run out of money if has legal tender laws, but that does not mean that “the government has an unlimited capacity to pay for the things it wishes.” The Gross Domestic Product (GDP) of the United States in 2016 was around $17 trillion.[4] If the government decides to spend $20 trillion of wealth and continues to spend more than the total output of wealth of the United States, then the Unites States will go bankrupt. The ability to print (create) more money will not matter. Venezuela has a central bank, but it has not saved Venezuela or allowed its government “to pay for the things it wishes.” The expected inflation rate in 2017 for Venezuela is 1,660% according to the IMF (International Monetary Fund) and its GDP fell 15% in 2016. It also did not save the Weimar Republic which had a central bank, and it did not provide the government an unlimited capacity to pay for the things it wishes. The MMT’s answer to the Weimar Republic is that they were forced to repay their war debts in gold. According to MMT governments with a central bank and legal tender can be infinitely wealthy, which is clearly absurd.

The problem with MMT is it confuses money with wealth. This is similar to how Keynesians reverse cause and effect, by arguing wealth is created by spending (consumption). The ideas underlying MMT were proposed by John Law, who created the Mississippi Company in France in the early 1700s and almost bankrupt the whole country.[5] It is a fascinating story, but beyond the scope of this article.

The U.S. government spends it currency into existence. This is important, too. The government spends first and then collects taxes. (Logically, this is how it began, or else how would people get the money to pay taxes?) Taxes are what give the dollar value. As Alfred Mitchell-Innes, a diplomat and credit theorist, once put it: “A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it.”

According to this statement then increasing spending causes inflation, while increases in taxes cause deflation. In the United States the Democrats (socialists) always want to increase spending and taxes, which cancel each other out according to MMT. Republicans (conservatives) want to reduce spending and taxes which would also cancel each other out by this theory. This analysis again confuses money with wealth and it ignores debt financing.

Another amazing thing about this statement is that if you or I “spent money into existence” it would be called counterfeiting and would be considered theft. Somehow when the government does this, it is okay and according to MMT stimulates the economy (creates wealth).

The parenthetical comment “else how would people get the money to pay taxes?” is easily refuted by history. People in the United States paid taxes, before the United States government had any legal tender. As a result, there was no way for the government to spend before it collected taxes. Even a cursory review of history provides numerous other examples, including early man in which there was no formal government. In addition, my earlier article on Banking shows that banks create money when they create loans, which any MMT advocate should know.

I cannot make any sense of the final statement that the value of a dollar is created because of the tax necessary to redeem it. This statement could only make sense to a totalitarian. Totalitarians believe that when the government spends money it gives up some of its power and when it taxes and redeems the money it redeems this power.

This article explains the mechanism by which money is created as:

The Treasury spends dollars into existence through the central bank. The central bank credits the accounts of banks, and banks credit whoever is getting paid. Taxes reverse the process. Banks then debit accounts, and the central bank debits the banks. The government cannot run out of credits.

Note that no liability is created by the government in this direct money creation and no one is paying interest on this money, just like no one pays interest when money is printed. There is a myth that all money in the United States (most modern countries) is created by a loan and that we have to pay the banks interest on all money created. This is incorrect, the money created by this direct money creation process is not a loan and no one pays interest to have this money.

This process of money creation is only possible because the government has legal tender laws. In my earlier article on Banking, I pointed out that legal tender laws were necessary for the government counterfeit money. Since a central bank is tasked with controlling the money supply they require legal tender laws. One of the fastest ways to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

In theory Congress has to first authorize spending first. However, in the United States we are not allowed to audit the Federal Reserve. Thus it is possible even likely that the Federal Reserve creates money (direct money creation as opposed to a loan) and no one knows about it. For instance, the Federal Reserve admitted that it could not account for $9 trillion of off-balance sheet transactions.[6] While these may have been loans (we don’t know because we cannot audit the Federal Reserve), it shows how easy it would be for the Federal Reserve (or Treasury) to just credit someone’s bank account without anyone knowing. Of course, I have no evidence of this, because we cannot audit the Fed, but human history would be on my side.

“Simple Inflation” under a Central Bank

In my earlier article on Banking and Inflation I defined simple inflation as that which occurs because of printing money or debasing the currency. This direct creation of money function the same as these processes. The amount of direct money created is equal to the total amount of money spent by the government, less the amount of taxes received, and less the amount of money borrowed by the government. When a government resorts to direct money creation to pay for a large part of their operations, it results in rapidly increasing inflation rates. Venezuela is the most blatant example today.

What we have learned:

*Central banks do not arise in a free market (capitalism) they are a distortion of the free market.

*Central banks require legal tender laws in order to fulfill their mission of controlling the money supply.

*The amount the government spends less the amount it taxes and borrows is the amount of money created by the government (government counterfeiting), which results in simple inflation.

*Modern Monetary Theory confuses money with wealth.

*The fastest way to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

Discount Window Lending

When most people think about the Federal Reserve (the central bank in United States) they immediately think about interest rates. The Federal Reserve mainly affects interest rates in the United States by it setting of the Federal Funds Rate and by the Discount Rate. The Federal Funds Rate is set by the Federal Reserve and is the interest rate at which banks lend reserve balances to each other. The Discount Rate is the interest rate that the Federal Reserve charges banks to borrow from the Federal Reserve. Both of these are related to the Federal Reserve’s function as a lender of last resort and are intended to prevent a “run on a bank.”

A run on bank is when a bank does not have enough cash (species) on hand to meet its customers demand. This can occur to a sound bank and just represents a cash flow issue or it can be the result of a legitimate lack of solvency and confidence in the bank. One of the main justifications for creating the Federal Reserve was to reduce the frequency of this occurring. The empirical evidence is a mixed on this issue. The Federal Reserve was created before the Great Depression and there were huge numbers of bank failures then. However, the number of runs on banks and the number of bank failures where depositors lost money have probably decreased in frequency since the Great Depression.

When the Federal Reserve changes the Federal Funds Rate or the Discount Rate, which they usually change at the same time, it affects the interest rates that banks charge. If the Federal Reserve increases either or both of these interest rates it usually causes banks to increase the interest rates they charge customers. Generally the goal of raising interest rates is to reduce the number of loans banks are making and thereby decrease the money supply or slow its growth. The opposite is true when the Federal Reserve lowers interest rates. Thus it is normally considered inflationary when interest rates are lowered and deflationary when interest rates are raised. Unfortunately, the empirical evidence is a bit murky on this issue. For instance, interest rates were very low during the Great Depression in the United States and the money supply was shrinking.[7] Milton Friedman and Anna Jacobson Schwartz argued that the Federal Reserve failed to fulfill their responsibility of lender of last resort.[8]

Since there appears to be some contradiction between the empirical data and the theory let’s examine this issue more closely. When the Federal Reserve increases interest rates above the free market rate the result is that some projects that would have made economic sense to fund with a loan no longer are. As a result fewer loans will be imitated by banks than would have been the case if interest rates were at the free market rate (the free market rate is the interest rate that banks would charge if there was no central bank). This will reduce the money supply. However this is a transient effect. Once the economy has adjusted to the new interest rates loans will be created at this new lower rate. At this point it is likely the money supply will grow (shrink) roughly at the same rate as the economy, as I explained in my earlier article on Banking. If the Federal Reserve raises interest rates too far above the free market rate it can cause a nationwide liquidity crises, which will destroy some wealth that was or would have been created. The government can destroy wealth, but it cannot create wealth only redistribute it.

If the Federal Reserve sets the interest rate lower than the free market rate but not too low, then more projects that would have not made economic sense to fund with a loan now are. This results in a one-time increase the money supply and after that it the money supply should grow at about the same rate as the economy. As a result, lowering the interest rate below the free market rate, but not too low, will result in a one-time increase in the money supply.

If a central bank lowers the interest rates too low, banks will refuse to initiate loans. How low? Well if the interest rate that banks can charge to commercial customers is the same as they can get on Treasuries, then the banks are not compensated for the risk and expense of initiating a commercial loan. Banks need to be able to charge interest rates to their commercial customers that compensates for the extra risk and expense involve over supposedly safe investments like Treasuries (government bonds). As a result, when interest rates are set too low by the central bank it results in a contraction of the money supply.

This shows that low interest rates (lower than free market rates) are not the cause of long term inflation and if the interest rate is too low it can be deflationary. This is likely what has been happening in Japan since the 1990s and happened in United States during the Great Depression. Other government policies can also effect how the economy behaves, which makes it hard to nail down the exact effect of the central banks policies. For instance, Friedman and Schwartz seemed to blame the Federal Reserve for everything that happened in the Great Depression, however it is clear that other anti-free market policies by Roosevelt and Hoover before him also contributed significantly to the Great Depression.

Central banks can also change the number of loans that are initiated by changing the reserve ratio requirement.

The commercial bank’s reserves normally consist of cash owned by the bank and stored physically in the bank vault (vault cash), plus the amount of the commercial bank’s balance in that bank’s account with the central bank.[9]

However, this also should have a one-time effect on the money supply. The result is that long term inflation is not caused by a central bank’s interest rate policy. A central bank’s failure to act as a lender of last resort may cause an extended period of deflation however.

Open Market Operations

Another tool of central banks is open market operations where the bank goes into the market and sells or buys securities, usually bonds. When a central bank buys securities it increases the money supply. This operation involves the central bank creating money (a computer entry without any associated liability) and then buying the securities, which puts money into the economy. As those bonds (normally the central bank buys bonds) are paid off it decreases the money supply. As a result, buying securities results in a one-time increase in inflation that is removed as the bond is paid back. Of course the central bank can continue to buy bonds if it wants to continue to inflate.

Alternatively, the central bank can sell securities, which results in a decrease in the money supply as private parties trade cash for the security. As the private parties receive payments from the securities (if they are bonds) the money is reintroduced into the economy. Each purchase by the central bank is a one-time decrease in the money supply (assuming the security is a bond) that is removed over time as the bond is paid back.

Both of the scenarios above assume that the central bank is buying or selling bonds (or other securities) at their free market rate. If the central bank over pays for a bond the amount that it overpays for the bond is a direct creation of money and is not redeemed as the bond is paid off.

When the bond is a government bond (national) and the central bank agrees to purchase the bond at a lower interest rate than the free market rate, then this results in the direct creation of money equal to the difference in the required payments in a free market verses what the government actually pays. This is clearly inflationary and very subtle.

When a central bank starts buying a significant percentage of the government bonds when issued, the most likely reason is that private buyers are not willing to purchase the bonds at the price (interest rate) the government wants to sell them at. This is one of the surest signs that the central bank is creating large amounts of money to finance the government. However, it is very subtle. It is very hard to calculate how much money has been directly created. If the central bank buys the government bonds near their real cost and requires payments based on tax receipts, then the amount of inflation is very small or not at all. The central bank can just quietly retire these bonds and then the inflation is huge. Since in the United States we cannot audit the Federal Reserve we have very little idea of what is really happening. Inflation caused by open market operations and interest rate targeting are subtle and hard to detect and I call the inflation caused by these operations “complex inflation.” Central banks and the legal tender laws they depend are designed to obscure what the government and central bank are doing. This allows for all sorts of mischief and inside deals.

Attempts to measure money creation, M0-M4, do not differentiate between these mechanisms and therefore are poor at predicting inflation.

How many companies did the Federal Reserve bail out in 2008? Did these companies really pay back these loans? We know for sure that banks were allowed to “borrow” huge sums money from the Federal Reserve at near zero interest rates and then “invest” this money in Treasuries. This was just a complex way of hiding the fact that the Federal Reserve created (printed) money and gave it to these banks. The procedure was obscure enough that most Americans would either not understand what was happening or would get bored when someone explained it to them. However, the money created was paid for by (really stolen from) all those Americans (and people forced to use US dollars around the world) who hold or work for US dollars. The bankers then paid themselves huge bonuses for their brilliant investment strategies.

Here is what we have learned:

*Central banks create money directly, although in theory in the United States with the direction of Congress and the Treasury. *When central banks change the interest rates it causes a one-time increase in inflation (deflation). Low interest rates do not

*Open market operations provide numerous ways to increase inflation that are subtle and hard to detect.

History of Central Banks in the United States

Many people label the First National Bank of the United States as a central bank. A central bank is different from a national bank, such as the First National Bank (FNB) of the United States setup during Washington’s presidency. The FNB was a private bank in which the federal government had a twenty percent equity interest. It was forbidden from buying government bonds, had a mandatory rotation of directors, it could not issue notes or incur debt beyond its capitalization, and the federal government could withdraw its money from the FNB and place it with another bank.[10] The FNB of the United States was a truly a private bank not a central bank. It did not set the policies that “affect a county’s supply of money and credit.” It also did not issue legal tender.

Hamilton and Washington pushed for a national bank because the national government had to be able to pay bills through-out the nation and a national bank made this easier than working with multiple different banks. Depending on a person’s view of central banking they either vilify Hamilton or think he was a genius. Both sides seem to confuse the national bank issue with the Hamilton’s efforts to put the newly formed United States government on sound footing. Hamilton’ s first report on public credit did not mention a national bank, it only dealt with the state and foreign bonds left over from the revolutionary war. The report called for:

1) Assumption of the state and foreign bonds that were trading around 20-25% of their face value.

2) Paying off these state and foreign bonds at their face value by issuing new federal bonds.

3) Tariffs and tonnage duties would back these new federal bonds.

The result of this legislation, according to Wikipedia was:

The adoption of Hamilton’s Report had the immediate effect of converting what had been virtually worthless federal and state certificates of indebtedness into $60 million of funded government securities. Fully funded, the central government regained the ability to borrow, attracting foreign investment as social unrest destabilized Europe. In addition, the newly issued bonds provided a circulating currency, stimulating business investment.[11]

Hamilton’s plan worked brilliantly and it had nothing to do with a National Bank.

The national bank was proposed in a separate report. Hamilton would not have been in favor of a central bank. Hamilton believed that a bank run by the government would be tempted print too much money.[12] The First National Bank was not a central bank, however it was a government chartered and supported enterprise sort of like Fannie Mae and not strictly a free market enterprise either. Such enterprises are prone to inside deals.

Most people point to the Second National Bank of the United States created in the Madison administration as a central bank. The Second National Bank was modeled after the First National Bank, except it had some regulatory authority over other banks. This made it closer to a central bank, however it did not have the power of legal tender or a monopoly on the issuance of money. Apparently, the Second National Bank was poorly run and became involved in politics. Andrew Jackson refused to renew its charter so its operations ended in 1836. The information I could find on the Second National Bank was sparse compared to the First National Bank.

The first real central bank in the United States is the Federal Reserve, which was created in 1913. The Federal Reserve is a private entity of sorts. It is more like Fannie Mae than a true private bank however. It has the power to create legal tender, it is tasked with setting interest rates to achieve policy goals, and it has regulatory control over the whole banking system in the United States.

There were two main justifications for the Federal Reserve: 1) the United States needed a lender of last resort to avoid banking panics, and 2) the idea that the United States government almost went bankrupt a couple of times, but JP Morgan saved the day.[13]

The United States did suffer from a number of bank panics, but these were due to over-regulation, not the free market. Oddly, finance (stocks and bonds) was not regulated at all in the United States until the Kansas’ Blue Sky Law in 1911, which was the blue print for the Securities Act of 1933. Banks on the other hand were highly regulated, the most obvious of these regulations were unit banking laws. Unit banking laws required that banks could have only one location and these laws existed in a number of states and was applied to federal banks. These resulted in a lack of diversification in banks’ portfolios, which increased their risk of failure.[14] Canada did not have these restrictions. Canada had many nationwide banks and as a result did not have a single bank fail during the Great Depression.[15]

Private banks had already created clearing houses that acted as a lender of last resort, before the Federal Reserve.

Friedman understood . . . that before the Federal Reserve Act financial panics in the US were mitigated by the actions of private commercial bank clearinghouses. Friedman and Schwartz’s view of the 1930′s was that the Fed, having nationalized the roles of the clearinghouse associations [CHAs], particularly the lender-of-last-resort role, did less to mitigate the panic than the CHAs had done in earlier panics like 1907 and 1893. In that sense, the economy would have been better off if the Fed had not been created. This position is perfectly consistent with the position that, provided we take the Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job.[16]

The idea that the United States needed a central bank, is not justified by the banking failures before the Federal Reserve and the Federal Reserve failed in this function during the Great Depression.

The other justification for the creation of the Federal Reserve was the supposed bailouts of the United States federal government in 1893 and 1907 by JP Morgan. The United States was on a gold standard and the governments gold reserves were being depleted rapidly in both cases. In both cases Morgan guaranteed to buy bonds issued to purchase gold for the United States Treasury. These bonds were sold on the strength and credit of the United States and Morgan profited by both of these so-called bailouts. If the Treasury had been doing its job correctly it would have cultivated a market for these bonds long before this crisis. In addition, the federal government could also have slashed spending. Not surprisingly the bailout of 1907 happened under the bad economic policies of Teddy Roosevelt. In addition, the United States had the power to issue legal tender, which it could have done to conserve its gold. The history surrounding these events is confused and has not been fully explored. This paper is not full exploration of this topic, however it raises serious doubts that the narrative of these panics was a legitimate justification for the creation of the Federal Reserve.

Another narrative pushed by the banking interests is that somehow banks are different than other businesses. Banks always argue that if one bank (large politically connected bank) fails then the whole banking system will collapse. This narrative is trotted out every time banks demand a bailout, the most recent being the bailouts in 2008. When a bank fails it goes through bankruptcy, which acts as a circuit breaker from a cascading series of failures. This is exactly what happens in other areas of the economy. Another solution that I do not endorse, but is better than bailouts, was the Resolution Trust Corporation that was created to liquidate the savings and loan failures of the late 1980s. The Resolution Trust Corporation was essentially a massive bankruptcy proceeding and importantly its existence was limited. It had to liquidate all its assets by 1992 (five year life).

The justifications of for the Federal Reserve are weak at best and considering the damage the Federal Reserve has done to the economy and its potential for abuse it should be ended. The origins of the Federal Reserve are based on government failure, specifically interference in a free market.

What we have learned:

*Central banks do not arise naturally in a free market and are not part of a free market.

*Central banks and legal tender laws are the source of inflation, not private fractional reserve banks.

*Central banks provide an easy way to obscure that the central bank and the government are creating inflation.

*Lowering interest rates causes a one-time increase in the money supply over the trend line.

*The fastest way to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

Was Midas Mulligan, the hero banker in Atlas Shrugged, running a fractional reserve bank? There has been much criticism of the Federal Reserves’ handling of our money supply and its effect on the economy. Much of this criticism has been led by Ron Paul and the Austrian school of economics. Some critics, including Ron Paul and Thomas E. Woods, author of Meltdown, have further argued that fractional reserve banking should be outlawed. Fractional reserve banking is how all modern banks (since at least 1750s) operate. Wikipedia defines a Fractional-reserve banking as a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loan to other customers. This means that available funds (called bank reserves) are only a fraction (called the reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

Ayn Rand clearly would have been against the Federal Reserve system, which her protégé Alan Greenspan headed for over a decade. The Federal Reserve is a government institution that prints money at will and manipulates the money supply for the benefit of government looters and Wall Street looters. In Atlas Shrugged, Rand rails against paper money and in Galt’s Gulch they use gold for their currency. However, to the best of my knowledge, she never addressed the issue of fractional reserve banking directly. The history of fractional reserve banking starts with the concept of an exchange bank. I explain in my book, The Decline and Fall of the America Entrepreneur: How Little Known Laws and Regulations are Killing Innovation:

Modern banking started in the early 1600s with the Bank of Amsterdam. Merchants could deposit coins with the Bank of Amsterdam and use this account to pay for transactions. Using checks, a merchant’s account was debited and another merchant’s account was credited. This meant that coins did not have to be transported from one merchant to another with the attendant risk of theft and loss or the cost of transportation. The Bank of Amsterdam was just an exchange bank that facilitated transactions between merchants. Next came the Swedish Riksbank established in 1656. The Riksbank was not only an exchange bank, it also lent money making it the first modern fractional reserve bank. Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Commonly, loans are made against collateral such as land or jewelry. … Some people believe fractional reserve banking creates money out of thin air, but what really happens was the money for these loans were backed by some collateral other than coins or bullion. The downside of other types of collateral is they are not as liquid as species (coins, bullion). As a result, if large numbers of customers of a fractional reserve bank wanted species (currency) at the same time, the bank would not able to fulfill all its customer’s demands. This is a classic run on a bank. A run on a bank is a cash flow issue. A sound bank may have plenty of collateral and performing loans, but if most of its customers demand species at the same time it will not be able to fulfill these requests. Fractional reserve banks free up capital from low performing assets so that they can be invested in higher performing assets. For example, if you owned a large tract of ranching land that was not highly profitable but represented a large amount of capital and you want to invest in an oil well, without fractional reserve banking you would have to sell some of the land in order to invest. With fractional reserve banking you could convert your land into a generally accepted form of money, by pledging your land as collateral to a bank for a loan. In the modern world, the loan to you is just a computer entry in your bank account.

It is clear from history that fractional reserve banks are not some sort of government institution, like the Federal Reserve. Rand’s philosophy was that people are free to contract with each other for anything that does not involve fraud or the use of force. A fractional reserve bank meets this requirement, with the one possible caveat that a bank should disclose this information to depositors so that the customer understands and assents to the use of his money this way. Since most people do not know what a fractional reserve bank is, including many bank employees, I am not sure that this caveat is met. I assume that when you open a new account banks provide you with information that they are a fractional reserve bank, but I have not been able to prove this. Without fractional reserve banking it would be very difficult to securitize (Collateralize) many assets, such as houses and land. This would significantly impede the economic growth of a country.

It is common for pundits to declare that the last two recessions were due to easy money on the part of the Federal Reserve. Both free market proponents, such as Austrian economists, and Keynesians agree on this point. David Faber even did a one hour show called the “Bubble Decade.” First, let’s distinguish between easy credit bubbles and investment manias. The recession of 2008 was clearly the result of excessive debt and is therefore a credit bubble. Not only did the Federal Reserve hold interest rates low, but more importantly the federal government pursued a number of policies to encourage overinvestment (borrowing) in the housing sector. Among these policies were the creation of Fannie and Freddie Mac and their investment in subprime mortgages and debt rating agencies, sanction by the SEC, that rated securities based on these mortgages as AAA. Both of these contributed to a false sense of security on the part of investors. It was believed that even if these securities (CMOs) failed the government would stand behind any mortgages backed by Fannie and Freddie.

Now compare this to the recession of 2000. There were no policies encouraging debt (or equity) investments in technology start-up companies. Banks do not loan money to even highly successful technology start-up companies. Even very accommodative money policies by the Federal Reserve do not result in direct loans to these companies. The Fed has small indirect effects. For instance, easy money by the Fed makes it easier for founders to mortgage their house (or other property) and invest in their start-up. Another indirect effect is that lower interest rates make it more attractive to invest in technology start-ups than debt instruments. A third indirect effect is low interest rates encourage margin accounts for stock investors. As a result, it is unlikely that the investment mania of the late 90s was the result of easy money policies on the part of the Fed.

Some people seem to believe that manias and bubbles can only occur because of easy money policies on the part of the Federal Reserve (Central Bank). This cannot be right, because the tulip mania of Holland reach its peak in 1623. This was before fractional reserve banking. The first fractional reserve bank was the Swedish Riksbank established in 1656. The first central bank was not established until the next century. Clearly, investment manias can occur without central bank.

Gold is one of the most sensitive barometers of inflation due to excessive money creation. The price of gold fell from about $400.00 an ounce in 1996 to below $300.00 per ounce in 1999 and most of 2000. This is not the sort of response we would expect in gold prices, if the Federal Reserve was inflating the money supply. The Discount Rate was 4 ½% in November 1998 and was increased to 6% by May 2000. Again this is not one would call an easy money policy. The investment mania in technology companies in the late 90s was not the result of over inflating the money supply. Part of the deflation of the late 90s was due to a rapid increase in the amount of goods and services being produced, due to the new technologies being developed. This may be one of the cases where the GDP measurement actually understated the actual growth.

The recession of the 90s was not caused by too easy money, but imprudent tightening of the money supply. Alan Greenspan was determined to cool the stock market. As a result, the Fed increased interest rates until they caused a recession. The yield curve turned negative 1999 or early 2000. A negative yield curve would never occur in a free market economy – that is without a central reserve bank. No one would ever loan out money for a longer term at a lower interest rate in than a shorter term loan. An inverted yield curve is the product of a central bank.

The economic growth of the 90s was built on companies developing new technologies, which is the only way to increase real per capita income. As a result, the recession of 2000 was relatively mild. Alternatively, the housing bubble was built on easy credit and did not result in new technologies. The recession of 2008 was the deepest since the recession of 1980.

The TARP bailout of Wall Street may be over but we are still bailing out the millionaires on Wall Street. The Federal Reserve has purposely set the fed funds rate to zero in order to “recapitalize” (bail out) Wall Street and the big banks. This is nothing more than crony capitalism, where middle class Americans are forced to bail out multimillionaires. As if this were not bad enough the bankers on Wall Street are acting like they are genius because they can borrow money from the federal government for zero percent interest and loan it back to the government at three percent interest. This transfer of wealth from the rest of America to the politically connected in Wall Street is not moral and it is not good for the country. An excellent video on this point is Huge, Ongoing Wall Street Subsidy Allows Banks to Coin Money Every Day at Savers’ Expense .

Pat Choate’s book “Saving Capitalism” points out that middle America has bailout Wall Street at least nine times since 1980. Many of these bailouts are framed as bailouts for a country such as Greece today or Mexico in the early 1990s, however the bailout funds are not used to help the people of Greece or Mexico they are used to pay back big banks that made bad loans.

The finance industry and Washington have conspired to steal all the wealth generated from hard working Americans. If we want our country to be great again and our economy to grow again Wall Street has to be allowed to fail and Washington’s budget needs to be cut in half.